The Real Cause of the Current Financial Crisis

The FHA Administrator chartered Fannie Mae (FM) on February 10, 1938.  The purpose of this organization was to codify the national commitment to housing and to address the inability or unwillingness of private lenders to ensure a reliable supply of mortgage credit throughout the country.  The primary purpose of Fannie Mae was to purchase, hold, or sell FHA-insured mortgage loans originated by private lenders. After World War II, Fannie Mae's authority included VA-guaranteed home mortgages as well.  In 1954 the Charter Act provided the basic framework under which Fannie Mae operates today.  The federal government still had direct control, however.  This act also stipulated how the secondary market operations would be transformed to the private sector.

The 1968 Charter Act split Fannie Mae into two entities: a reconstructed Fannie Mae and Ginnie Mae (GM).  GM was to remain a federal agency responsible for assistance programs while FM became a "government-sponsored private corporation" or what we call today, a "Government-Sponsored Enterprise" (GSE).  This act also authorized FM to issue Mortgage-Backed Securities (MBS) and put into place a regulatory framework overseen by the Department of Housing and Urban Development HUD.

In 1970, the Emergency Home Finance Act created Freddie Mac.  This was essentially in response to concerns over the virtual monopoly enjoyed by Fannie Mae in the secondary market due to the federal protections afforded this GSE.  Freddie Mac and Fannie Mae operated under what was essentially a 'separate but equal' regulatory and oversight framework.  This law also required the HUD Secretary to approve Fannie Mae's business dealings.

In 1984, the Secondary Mortgage Market Enhancement Act updated HUD's regulatory power and authorized Fannie Mae to purchase subordinate lien mortgages.

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 made regulation of Fannie Mae and Freddie Mac consistent under HUD oversight.  It also instructed the Treasury Department and the GAO to conduct studies that led to the regulatory overhaul in 1992.

Now I know this has been rather boring up to now but it lays the framework for what is about to take place.  The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 overhauled the regulatory oversight of Fannie Mae and Freddie Mac. The Office of Federal Housing Enterprise Oversight was created as a regulatory office within HUD with the responsibility to "ensure that Fannie Mae and Freddie Mac are adequately capitalized and operating safely." This office is authorized to act without HUD oversight on a range of regulatory issues.  It also established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas.

This last statement is key and you need to remember this.  Starting in 1993, HUD mandated that a certain percentage of Fannie Mae business had to be in three categories: low- and moderate-income, underserved, and special affordable.  The goal was to increase home-ownership among minorities and the poor in rural and urban areas.  Keep this in mind and we will come back to this later.

            Let us step back in time once again to 1977.  It was in this year that the Community Reinvestment Act (CRA) was signed into law by President Carter.  The purpose of this act was to "require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions."  In addition this act mandated that the appropriate Federal financial supervisory agency should assess the institution's record of meeting the credit needs of its entire community, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of such institution; and take such record into account in its evaluation of an application for a deposit facility by such institution.

            The CRA was mainly targeted towards the four supervisory agencies: the Board of Governors of the Federal Reserve System (the Board), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS).  When these agencies conducted inspections of the banking institutions under their purview they were to evaluate how well the said institution had complied with CRA.  This record of compliance was taken into account when and if the institution submitted an application for a charter, a merger, an acquisition, a branch, an office relocation, or deposit insurance.  In other words, for a bank to expand and grow, they had to be able to prove that they were lending and providing other services to low- and moderate-income residents in their service area in sufficient numbers.

            The problem for the deposit and lending institutions was that the text of the law itself actually set no guidelines to show compliance and therefore the regulatory agencies held hearings to settle the issue.  Even then, the guidelines were still somewhat vague and quite flexible in their approach.  It was difficult for the deposit and lending institutions to know exactly what would increase their compliance, as there were two parts to an examination record, a public record and a confidential record.  The deposit and lending institutions rarely knew what was contained in the confidential record and could not know who gave that information if they did obtain it.

            To address some of the resulting concerns Congress amended the CRA in 1989 to require public release of these examinations.  With community groups becoming more organized and better informed, they started to make more demands and protesting ever-increasing numbers of applications from deposit and lending institutions. New guidelines issued concurrently with this amendment appeared to demand great emphasis on documentation as the deposit and lending institutions had to show compliance through day-to-day operations.  Because of this perceived undue hardship, new guidelines were once again issued in 1992 which specifically said that a lack of documentation would not be the sole determinate of a poor rating.  However, it was also stated that any well-run program was expected to include documentation.

            Even with all this involvement by the regulatory agencies, however, real progress towards the stated goal of increasing numbers of low- and moderate-income homeowners was considered spotty at best and generally unacceptable by many in the regulatory agencies, in Congress and among community activist organizations.

            Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 in an effort to address the above problems.  This act created the Office of Federal Housing Enterprise Oversight (OFHEO) with HUD to oversee Fannie Mae and Freddie Mac (FM2) and to ensure their continued economic stability and safety.  It also established housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas to be set and enforced by HUD.  In 1993 and 1994, the law established these goals with the goals to be set by HUD in 1995 and onward.  This mandated that a certain percentage of loans purchased by FM2 had to be written in low- and moderate-income, underserved, and special affordable areas.  In other words, Fannie Mae and Freddie Mac were forced to buy sub-prime loans in considerable numbers.

            What are the unintended consequences of these actions?  Prior to 1992 and the passage of the Federal Housing Enterprises Financial Safety and Soundness Act if a lending institution wrote a sub-prime loan they essentially had to accept the risk of making that loan, of whether or not that loan would be repaid.  FM2 would not purchase the loan because sub-prime loans did not meet their guidelines.  Therefore, not that many sub-prime loans were written and those that were written generally performed fairly well.  But with the passage of this act, and the resultant lowering of FM2 guidelines to purchase sub-prime loans, these lending institutions could now make them with impunity.  The lending institutions could make their money on origination fees and other charges while pushing the risk of the loan actually being repaid onto FM2.  Thus, from 1992 onward, the number of sub-prime loans ballooned dramatically.  Everyone applauded the great increase in the number of low- and moderate-income homeowners.  Very few noticed the risk to FM2 and the entire financial system.

            There were signs of trouble that were mostly ignored.  Amid investigations of mismanagement and questionable accounting practices and charges of outright fraud, the Bush administration proposed a new regulatory agency under the aegis of the Treasury Department.  The New York Times reported on September 11, 2003, ''The regulator has not only been outmanned, it has been out-lobbied,'' said Representative Richard H. Baker, the Louisiana Republican who has proposed legislation similar to the administration proposal and who leads a subcommittee that oversees the companies. ''Being underfunded does not explain how a glowing report of Freddie's operations was released only hours before the managerial upheaval that followed. This is not world-class regulatory work.''  The same article contains the now famous quotes from two Democrats:

''I don't see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,'' Mr. Watt said.

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